To Judge a Tempting Stock, Consider Risks versus Profits

To Judge a Tempting Stock, Consider Risks versus Profits

Article excerpt

ALL KNOWLEDGEABLE INVES-tors know that buying a stock means they
are purchasing a share of a company's future earnings, not those of
its past. But they also know that to ignore history is a mistake,
because it provides a context with which to judge the likelihood of
their expectations for future earnings, and future-earnings
expectations are critical to any stock selection.

This means they carefully analyze companies when they are touted
by analysts as having great future prospects but they don't have a
record of consistently growing positive earnings and, perhaps,
dividends and they are selling at price-to-earnings ratios (P/E's)
many times the market's P/E of 16.

These investors wonder: what if the analysts are wrong, and will
the price collapse? They have to decide if that risk is outweighed
by the hope for future solid earnings growth and stock appreciation.

Unfortunately, based on the historical record, the answer is no.

But then the natural question is why investors push a stock to a
high valuation unsupported by solid earnings. The answer is
excitement and hype. These can blind investors to the company's real
value. Also, these stocks are sometimes thinly traded, so the most
optimistic buyers set the market price.

Which brings us to Palo Alto Networks, a company touted by
analysts even though, according to the respected research firm
Zacks, it lost 77 cents a share in fiscal year 2014. It's a company
in the computer security business with products such as a firewall.
The stock trades on the NYSE (ticker: PANW). It recently traded at
$98 a share and is ahead about 70 percent year-to-date. We will look
at one screening analysis that can help an investor evaluate a stock
like PANW.

Some data investors should consider:

Zacks' consensus estimate is for Palo Alto Networks to lose 38
cents in fiscal year 2015 and earn 11 cents in 2016. Other company's
estimates for PANW are much more optimistic, for example, 69 cents
for 2015.

Zacks' long-term earnings-growth-rate estimate is 25 percent;
some others are as high as 42 percent.

PANW's $98 price with negative recent earnings does not allow for
a calculation of a meaningful P/E ratio. …